Plan to reform fund boards is a pipe dream

Your Funds

The mutual fund business is the proverbial camel, the one that was supposed to be a horse until it was built by committee.

It is filled with arcane rules and procedures that can make funds perform more like beasts of burden than thoroughbreds.

And while investors have worked their way over the hump and have successfully used mutual funds to reach their financial goals, it's hard not to wonder how the business could be improved.

That's what made a recent book, Competitive Equity: A Better Way to Organize Mutual Funds, such a compelling story for investors. The book, co-authored by Peter Wallison and Robert Litan, calls for deregulating the mutual fund industry, eliminating fund boards, and relying on full-time trustees to protect the interests of shareholders.

Having fund firms set their fees without any say-so from directors would lead to price competition and an all-in-one/easy-to-understand fee structure, they say. "We're not proposing to throw out the existing structure, but we're proposing a parallel investment vehicle to work in a different way and compete with the existing structure," says Wallison. "If the new structure is superior - as we think it will be - eventually it will supplant the existing structure."

For now, that's a pipe dream.

To see why, let's examine the fund structure the authors are looking at, why it won't work now, and what the fund industry can learn from it.

Wallison and Litan's argument focuses on high fund fees and how excessive costs hurt investors.

The structure of a mutual fund, governed by the Investment Company Act of 1940, is a big part of the problem, because the board of directors is not built to encourage any form of price competition, according to Wallison.

Wallison compared the situation to electric utilities seeking a rate increase or justifying its cost structure by working with the local utility commission to pre-determine profits.

By law, a fund's board is supposed to see that their charges are well-run and to negotiate the best-possible fee structure. In practice, few boards put themselves on the firing line and fight cost increases or fire bad managers.

"If you eliminate the board's power to set and approve the adviser's fees and expenses, the managers are put in a position where they can set their own fees and expenses," Wallison explains.

"That allows them to cut costs in order to be more competitive, and once competition takes over, costs can come down and investor returns will benefit."

It's an appealing argument, but eliminating the fund boards is a drastic step, because the governing body does help resolve the conflicts of interest between fund companies and their shareholders, where management and investor interests aren't always aligned.

But the theory is little more than a pipe dream. While the Securities and Exchange Commission hasn't said anything negative about the book's proposals, they also haven't endorsed anything. And the "managed investment trust" - the new investment vehicle Wallison imagines as a competitor for the mutual fund - currently exists on paper only.

In all likelihood, it would take legislative action to amend the 1940 act to make it possible. That most likely means there needs to be a triggering event, such as another scandal in the industry that gets politicians thirsty for change.

Barring that, investors should consider the current alternatives to traditional mutual funds, including exchange-traded funds and closed-end funds. ETFs can, depending on their structure, have cost advantages over their traditional index-fund peers; closed-end funds frequently trade at a discount, allowing investors to purchase assets on the cheap.

Regulators may not want to go all the way to a managed investment trust structure, but creating a new investment product that runs like a horse would be an interesting change.

The new vehicle would have all-in-one pricing - so that investors are certain what they are paying for and how it is used - performance fees that align management interests with those of investors, and some form of oversight that protects shareholders and encourages price competition.

Says Wallison: "We want to make sure that price competition occurs in the mutual fund industry as it occurs in every other field of the economy today. The academic studies show that with very rare exceptions, all funds produce over time about the same results in performance, with the real difference in performance coming from costs.

"If you can create a structure where there's more price competition, everyone in the business will try to find more economical ways to offer collective investment services, and we'll all be better off for it."